Latin America: M&A anti-corruption due diligence

May 2013 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD

Financier Worldwide Magazine

May 2013 Issue

Rapid growth in Latin American markets present attractive business opportunities for investors, as demonstrated by significant private equity investment during 2012, up 21 percent from 2011, according to the Latin American Private Equity and Venture Capital Association. While the investment opportunities may be plentiful, so too are the countries in the region that are identified as ‘corruption-prone’, including Brazil, Mexico and Venezuela, which are rated low on Transparency International’s 2012 Corruption Perception Index.

One thing that is certain – the investment opportunities in Latin America are not without considerable risk. Investors pursuing them without conducting anti-corruption due diligence may substantially increase their chances of enforcement actions by the Department of Justice (DOJ) or the US Securities and Exchange Commission (SEC) for violating the Foreign Corrupt Practices Act (FCPA). Since 2004, the DOJ and SEC have been aggressively enforcing the FCPA, which prohibits companies and individuals from bribing or offering bribes to foreign officials for the purpose of obtaining or retaining business. Many of the enforcement actions initiated have involved bribery activity in Latin American countries.

Significant FCPA enforcement related to M&A transactions

The recent ‘Resource Guide to the U.S. Foreign Corrupt Practices Act’ (the Guide) issued by the DOJ and the SEC in 2012 devotes substantial attention to FCPA issues regarding M&A, specifically successor liability, which deems that a purchaser of a company may be held liable for the target company’s pre-acquisition FCPA violations. Accordingly, much of the FCPA’s enforcement involves M&A transactions – a trend that will likely continue as foreign investment in emerging markets increases.

Understanding this risk, the DOJ and SEC emphasise the importance of pre-acquisition due diligence and post-acquisition integration of the target into the purchaser’s FCPA compliance program. In summary, the Guide presents the following steps as necessary components of anti-corruption due diligence: (i) interview target management, including those in charge of the legal, sales and audit functions; (ii) review target’s sales and financial data, customer contracts, and third-party (distributor, sales representative, etc.) agreements; (iii) perform a risk-based analysis of the target’s customer base; (iv) review the target’s due diligence on its agents, intermediaries and other third parties; and (v) audit select high-risk transactions.

As the Guide notes, robust anti-corruption due diligence will enable the purchaser to identify the enforcement risk arising from pre-transaction FCPA violations committed by the target, its employees and agents and permit the purchaser to better assess the transaction. More importantly, the Guide makes clear that the DOJ and SEC will view the failure to perform comprehensive anti-corruption due diligence as evidence that the company lacks a commitment to FCPA compliance.

Recent enforcement, including the Watts Water, Diageo and Ball Corporation cases, highlight the importance of anti-corruption due diligence in M&A transactions where the target company posed potential corruption risks. In these cases, the SEC entered settlements with companies for violations of the FCPA based on the pre-acquisition misconduct of recently acquired targets.

Mitigating risk in M&A transactions

Quite often due diligence is conducted within a very limited time frame. Two areas of anti-corruption due diligence that are often overlooked include a target’s practices with regard to third party due diligence and an assessment of sample high-risk transactions in order to mitigate the risk that payments might be improperly recorded or lack supporting documentation. During an acquisition, the absence of these crucial steps on the part of a purchaser in conducting due diligence often leads to FCPA exposure. This represents a significant risk, including reputational damage or even criminal charges, for the purchaser, its management and board of directors.

One of the most common violations of the FCPA is the mischaracterisation of bribes in the ‘books and records’ of the target. Bribes are often recorded as legitimate payments; such as commissions, consulting fees, or sales, marketing and miscellaneous expenses or accounts, and may include payments to fictitious vendors or payments for nonexistent services. These payments and accounts should be reviewed as part of the M&A due diligence process. At the beginning of a review, data analytics, such as trending and variance analyses, should be performed to identify a smaller population of transactions for a more substantive review by forensics professionals. This in-depth review should identify any mischaracterised entries.

As one would expect, transactions involving bribery are often missing supporting documentation or the documentation that is available is purposefully vague. This is commonplace with respect to invoices from processing agents, such as freight forwarders or transportation and logistics providers. For example, an invoice from a freight forwarder may include a general description such as “transportation of product from A to B, custom duties and custom processing” and an invoice amount for these activities without supporting details or documentation. Frequently, such payments include corrupt payments to customs or other governmental officials to expedite the process. The purchaser should, as part of the due diligence process, request invoices from processing agents that include the appropriate level of detail and supporting documentation in order to verify that the invoiced amount does not include bribes to foreign officials.

Challenges presented by third party representatives

Under the FCPA, a company is responsible for the actions of its agents, intermediaries, consultants and other third parties (the ‘third parties’). However, conducting due diligence on third parties is not common in Latin America and companies typically do not conduct any anti-corruption related due diligence on third parties hired to interact with government officials. Moreover, individuals are often hired specifically because of their personal relationship with a governmental official, which are leveraged to obtain business for the company.

Purchasers are well-advised to scrutinise the processes that a target has utilised to retain third party representatives prior to retaining these parties themselves, and evaluate the process for overseeing and monitoring their activities and payments. Contracts and payments to the third-party representatives should also be closely reviewed to identify red flags indicating that representatives may be engaging in prohibited conduct. Red flags may include payments requested in cash or in an unrelated currency, excessive commissions, or payments made to a separate party or to a bank account in a country other than the one in which the representative operates or is domiciled.

As investments in Latin America continue to grow, private equity and venture capital firms active in this developing market are increasingly exposed to potential FCPA violations, at times unwittingly through the prior activities of their targets. Consequently, companies should expand their financial and compliance due diligence to include procedures designed to identify corruption risks. Conducting an in-depth review of the target’s high-risk transactions and a target’s dealings with third parties is not only prudent, but necessary to mitigate risk and potential reputational damage, or even criminal charges.

Martina Rozumberkova is a director at BDO Consulting. She can be contacted on +1 (617) 239 7010 or by email: mrozumberkova@bdo.com.